The Case Against The Paulson Plan

I think this guy makes some very good points. A bailout will mean business as usual. Paulson already missed the opportunity to sunset the FNM/FRE empire. Why can't these assets be sold to investors if they are as good as we're being told they are?

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By Jeffrey A. Miron
Special to CNN

Editor's note: Jeffrey A. Miron is senior lecturer in economics at Harvard University. A Libertarian, he was one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan.

Economist Jeffrey Miron says the bailout plan presented to Congress was the wrong solution to the crisis

CAMBRIDGE, Massachusetts (CNN) -- Congress has balked at the Bush administration's proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the "troubled assets" of financial institutions in an attempt to avoid economic meltdown.

This bailout was a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

The opinions expressed in this commentary are solely those of the writer.

I saw one of the House republicans yesterday explaining their alternative, and it made sense. One, get the FDIC to raise deposit insurance limits to prevent runs on banks. Two, relax the mark to market requirement, which the SEC can do any time. Three, create an insurance program for these troubled assets. I believe he wanted to eliminate cap gains taxes on these asssets as well to encourage private investors to buy them.

I don't think these are crazy ideas at all. Paulson has dismiised them out of hand, but I don't see the administration doing anything other than running aorund in a panic.

I don't think these are crazy ideas at all. Paulson has dismiised them out of hand, but I don't see the administration doing anything other than running aorund in a panic.

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Paulson dismissed them because his goal from the beginning was to steal from taxpayers , reward his friends on WS and secure his future employement with them. He is on his way out and cares about his interest only.
He wanted Goldman Sachs oversight the Bailout !! What a pos !

Couple of days ago I would have dismissed what you're saying, but I don't see the administration taking steps it can take now without congress. Ditto the morons at the Fed, who should be marched down to the courthouse for a show trial.

I think we need the following:

1. Adopt House Republicnas' plan.

2. Immediate 75 BPS rate cut.

3. Immediate resignation of Paulson and Bernanke. There has to be some accountability somewhere.

4. Immediate prosecutions of ceo's from FNM, FRE, WM, WB. How can this lying POS Steel from Wachovia go on Tv and say everything is fine and the bank is closed the next week? I hope the class action lawyers tear this guy limb from limb.

How can that POSSIBLY be an issue other than psychological? Rates at 2% or 1%... money is virtually free in either case. A MAJOR part of the problem has been "too low of rates for too long".... how can lowering them again now be of any REAL benefit at all?

How can that POSSIBLY be an issue other than psychological? Rates at 2% or 1%... money is virtually free in either case. A MAJOR part of the problem has been "too low of rates for too long".... how can lowering them again now be of any REAL benefit at all?

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The root of the problem is real estate. Low rates will provide a floor and encourage investors to bottom pick.

Low rates also are a huge backdoor subsidy to the financial sector.

I wouldn't discount the psychological significance either. Either we are in a crisis or we're not. We should be doing everything possible if it is legitimately a crisis. By doing nothing, Bernanke gives the impression he's not as worried as Paulson.

I see little downside to a big rate cut here. It's not the time to play it safe.

I have to disagree with an implication that subprime lending is a causative feature of the current problem, as Miron seems to imply. In my opinion, his thinking is rather flawed on this point.

Subprime lending was a good thing and worked very well with losses under control when it was first encouraged in the seventies. At that time subprime borrowers had to qualify for loans and there were still reasonable credit requirements in place.

The current mess began to blow up in the nineties with widespread securitization (a good thing when properly regulated) and consequent separation of borrower from ultimate lender (acceptable only if the security ratings properly reflect risk, and the paper trail between security and underlying is not lost).

The reality of the current crisis is that those who sold mortgages had a financial incentive to ignore the credit worthiness of the borrower. Those who securitized the mortgages had an incentive not to delve too deeply into the underlying's risk profile, and they even hired rating agencies to tell them how to package the securities to get the best ratings. The rating agencies paid zero attention to confirming credit worthiness of the underlying and simply accepted data from the securitizers at face value, because they had a financial incentive to do so, and because they could point to their long standing practice of rating on the basis of data supplied by their clients. The credit default swap originators had a financial incentive to undervalue risk.

These are the features that led to the current crisis. Subprime loans are strongly correlated with the problem, but they are in no way causative! This is a very important point that all who are involved with correcting the current situation should understand.

Subprime lending is a valuable feature of the mortgage landscape and should be preserved. Let's not through the baby out with the bathwater.

".. Subprime lending is a valuable feature of the mortgage landscape and should be preserved.

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BULLSHIT! It's nothing more than "affirmative action" lending. THAT'S THE BASIS OF HOW WE GOT INTO THIS MESS.. granting ridiculous mortgages to unqualified borrowers... thanks to Clinton, Obama, GreenScam and the DemoCrapic Congress...

The cost and responsibility of a mortgage knows no racial nor socioeconomic bounds.

Either you can or CANNOT.... FINANCIALLY qualify for and carry the fair cost of borrowed money... doesn't matter whether you're a minority, or other*.

* Unless you're a DemoCrap, of course... willing to sell your vote for a handout at the expense of others..

BULLSHIT! It's nothing more than "affirmative action" lending. THAT'S THE BASIS OF HOW WE GOT INTO THIS MESS.. granting ridiculous mortgages to unqualified borrowers... thanks to Clinton, Obama, GreenScam and the DemoCrapic Congress...

The cost and responsibility of a mortgage knows no racial nor socioeconomic bounds.

Either you can or CANNOT.... FINANCIALLY qualify for and carry the fair cost of borrowed money... doesn't matter whether you're a minority, or other*.

* Unless you're a DemoCrap, of course... willing to sell your vote for a handout at the expense of others..

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What about guys like Ed Mcsomething....(Johnny Carson's sidekick)? His house is being foreclosed too.